Critical economic issues facing the new government

What are the key issues that the new government will have to face as it begins its term?

Of the many problems the new government inherited, the main economic challenge would have to be to implement structural reforms and policies to raise the UK’s potential growth rate and productivity. In particular, restructuring the fiscal framework to enable policies that drive public investment and can attract private investment.

High productivity and a strong, healthy workforce, among other factors, are key to driving output growth. However, UK productivity growth has been weak by historical and international standards since the global financial crisis. NIESR has subsequently argued that the current fiscal framework is not fit for purpose because it confines the government to a set of arbitrary ‘fiscal rules’ that discourage public investment. Furthermore, UK investment spending – both private and public – relative to the size of the economy has been consistently lower than in other advanced economies for decades. This has contributed to the poor economic performance since the 2008 financial crisis.

In addition, these problems have been compounded by labour market conditions. While the rise in inactivity may not have been the primary cause of labour shortages in recent years, it has contributed to a tighter than average labour market compared to historical standards. Therefore, in my view, current labour market conditions are also a contributing factor to the economic slowdown and I would urge the new government to introduce targeted interventions to help people return to the labour force.

Inflation has fallen to 2 per cent and interest rates have remained unchanged since August last year. What do you think we can expect from the Bank of England in the coming months?

CPI inflation has fallen significantly over the past two years, from a peak of 11.1 percent in October 2022 to its current 2 percent in June 2024, largely reflecting a combination of falling energy and food prices. However, just because core inflation has reached its 2 percent target does not necessarily mean it will remain there indefinitely, and we need to remain vigilant about upside risks that could put upward pressure on prices. Major central banks around the world are slowly starting to provide guidance on phasing out tight monetary policy, with some even starting to cut interest rates (e.g. the ECB and the Bank of Canada). As a result, attention has naturally turned to the Bank of England’s Monetary Policy Committee (MPC) for its next steps, especially as the core rate has reached its 2 percent target.

However, I would like to emphasise that different countries have different structural dynamics of core inflation and from a UK perspective, services inflation remains highly persistent – ​​driven by strong wage growth. While the data is encouraging and it looks like the first cut in the base rate will come in the third quarter of this year, the MPC wants to ensure that the decline in services inflation that we have seen so far continues. The two most important factors supporting the disinflation process have been energy and food prices, which have been falling for the last 20 months. Looking ahead, the downward pressure from these factors will fade and sustained and stable inflation at 2 per cent will only be possible by bringing services inflation – currently at 5.7 per cent – ​​under control.

Looking at the bigger picture, we can expect inflation to remain volatile but close to the Bank of England’s 2 percent target unless upside risks from geopolitical events materialize in a significant way. Geopolitical developments are changing day by day: the war in Ukraine continues and recent events in the Middle East have raised the possibility of it escalating into a regional conflict, which risks increasing inflation again due to supply chain disruptions.

That said, Bank of England Governor Andrew Bailey signalled in the June MPC minutes that the time for monetary policy normalisation was nigh, as two MPC members voted to cut interest rates at the June meeting. Therefore, if the geopolitical situation does not deteriorate and wage inflation remains under control, we could expect the MPC to start cutting interest rates as early as August.

Elevated real wage growth in the labour market is one of the key factors contributing to persistent services inflation. Where is the UK labour market now and where do you see it heading?

Policymakers and forecasters like me have found analysing the labour market a challenge over the past year, as continued uncertainty about the quality of data has hampered our analysis. However, we expect the ONS’s ‘Recast Labour Survey’ (due in September) to provide key insights into the state of the labour market.

According to estimates from the Labor Force Survey (LFS), the labor market is showing signs of cooling as job openings continue to fall and unemployment is rising slightly. In the three months to April, the employment rate was 74.3 percent, the unemployment rate was 4.4 percent, and the inactivity rate was 22.3 percent. The latter two remain above pre-pandemic levels. Turning to a more representative measure of labor market tension, the vacancy-to-unemployment (V/U) ratio was 0.6 in the three months to April, or 1.6 unemployed people per vacancy. While the labor market remains tight by historical standards, it is now much looser than it was at the height of the pandemic, when there were fewer workers available. However, the elephant in the room remains high inactivity (neither working nor looking for work). There are 9.4 million inactive people, a significant portion of whom are chronically ill, more than 2.8 million people. More specifically, since the pandemic, the number of people economically inactive due to long-term illness has increased by around 0.8 million.

Moreover, as wages continue to catch up with inflation, real incomes will continue to rise. Average regular earnings (excluding bonuses) were up 6 per cent in the three months to April, and our wage tracker forecasts that wage growth will slow to 5.2 per cent in the second quarter of 2024. Indeed, as the labour market continues to ease through falling job openings and rising labour supply, we can expect wage growth to moderate in the short term as the pressure to attract workers eases. CPI inflation has now returned to target against a backdrop of fairly strong wage growth, which is helping workers rebuild their real earning power, which was eroded during the cost of living crisis. However, in the longer term, addressing the challenge of labour market shortages will require implementing reforms to improve labour supply.